New corporate tax regime: Tax havens, MNCs to lose out

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Every now and then, media shed light on how individuals and corporations manipulate offshore dealings to book mighty profits. Exposes nicknamed Paradise Papers, Panama Papers and Pandora papers happen because countries compete with each other to capture capital investments, generate employment, and multiply their revenue collection. In their endeavor to acquire these benefits and to lure MNCs that are always on a lookout to reduce tax burden, the governments cut corporate tax rates. The highly competitive landscape has widened the difference in tax rates between countries. This creates tax competition and what experts call Base Erosion and Profit Shifting (BEPS).

An IMF study demonstrated that a 1% cut in a country’s corporate tax rates raised its revenues by 1.5%. This justifies why countries are in a never-ending race to the bottom on corporate taxation. The mismatch in tax rates and the myriads of bilateral tax treaties concluded by various countries with the noble intention to narrow the gap and avoid double taxation has indeed been dishonoured with tax treaty shopping by individuals and corporations. Of late, policy makers and negotiators have been trying to close the mismatch and narrow the gap that persists between where corporations do business and where they book profits.

The situation has its roots in the inability of the conventional corporate tax laws to adapt to the dynamism of the digital economy, leading to a greater mismatch between the tax systems followed in different countries. Perhaps, the gap has widened as the global economy started galloping towards digitalisation. It has become easier than ever for firms to register their intangibles in a tax haven like Bermuda or some Caribbean island and report their profits there.

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The OECD and the G-20 countries launched the BEPS project in 2013 to standardise the tax laws and bring about a greater coherence and transparency in domestic norms and rules that impact cross-country activities. The OECD has crafted and published a multi-step strategic plan to facilitate a coordinated tax plan and to focus on addressing the tax challenges that arise from a digital economy. The consensus-based solution framework had two pillars — one on creating a nexus and on profit allocation, and the other on arriving at a threshold global tax to address the BEPS issues.

The negotiation is almost complete and has culminated in a historic deal that is expected to come into effect in the near term. The fact that this initiative has received concentrated efforts from over 135 countries that make up to 90% of the world’s GDP reveals the significance of the deal. Some of the tax havens including Ireland, Hungary, Estonia, etc. registered their resistance initially and their reluctance isn’t surprising. It has to be noted that Ireland has a lean corporate tax of 12.5% and Hungary has a rate of 9%.

After several rounds of negotiations, Hungary, Ireland and Estonia agreed to the terms of the deal last week. Kenya, Nigeria, Pakistan and Sri Lanka have not turned up yet.

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The new deal in corporate taxes

The global minimum tax rate and other provisions that are part of this deal aim to make the global economy a level playing field by ending tax competition, tax evasion and tax treaty shopping. In June, the finance ministers of G7 economies met in London to seal a global minimum tax rate of 15% on companies with annual revenue of more than 750 million euros. It is estimated that the historic deal could garner $150 billion in additional global tax revenues every year.

Beyond finalising the global tax rate, the accord has laid down new rules for the digital era. The regulations are focused on consumer-oriented businesses that undertake digital transactions, categorized under the Automated Digital Services (ADS) and the Consumer Facing Businesses (CFB).

Big Tech companies would be required to pay taxes in countries where they sell their goods, irrespective of whether they hold a physical presence in the country. However, the deal requires countries to withdraw and abrogate all the digital services act that they had erected to regulate the digital landscape. They should also commit to not introduce any such measures in the future. The action plan is spearheaded towards achieving better tax compliance with an ultimate aim of ensuring that the profits are shared fairly based on value creation.

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The winners and losers

Advancements in technology accelerated by the mobility of capital, increased specialisation in business functions and activities, and a reduction in trade barriers have amplified the share of intra-firm trade among multinational enterprises. The intra-company transactions in terms of sales, and licensing of the intellectual property are of utmost significance for the MNE’s and any restrictions on such operations would disrupt the overall efficiency of such organisations. Such inefficiencies and distortions may proliferate rapidly throughout the entire value chain to impact various macroeconomic factors.

Because Intellectual property and intangible assets are proven to drive significant value and a greater competitive advantage to multinational enterprises, the effect would be even more significant for companies and countries whose financial returns rely more on intangibles. As the regulations are focused on altering the fundamentals of MNCs, the IP structure, and the financial holding arrangements might be impacted the most.

Evidently, those developed countries where MNCs, particularly the big tech companies like Apple, Google, Amazon and Facebook, were making a lot of sales, but booking petty profits while diverting their income to tax-paradises would emerge victorious. MNCs may now relocate capital to the country where they are headquartered and this may boost the economic landscape of that country. It is estimated that taxing rights on $125 billion of profits would be diverted to be booked in the country where it was earned instead of doing so in a tax haven.

Some less developed countries where MNCs have erected their manufacturing facilities could also gain. The clear losers will be the tax havens that were surviving on the inflow of capital which was made easy by the shrinking distances between countries due to digitalisation, liberalisation and globalisation. Ensuring a level playing field will decide the real success of the accord, though.

Reforming the tax landscape and tackling harmful tax competition is a big step forward. Securing a deal that sets sight on the future of corporate taxation is indeed momentous and remarkable.

(Dr Badri Narayanan Gopalakrishnan is founder and director of Infinite Sum Modelling. Sumathi Chakravarthy is partner and director, Infinite Sum Modelling, and Sindhu Bharathi is senior research analyst at Infisum Modeling Pvt Ltd, India.)